Accounting for working capital

Definition:

The working capital of an entity is defined as the difference between current assets and current liabilities. It is an interpretation of how liquid the company is in the short term.

A positive working capital indicates that the company has enough money to pay off its debts and is financially stable whereas a negative working capital indicates an imminent bankruptcy.

Current assets are those assets that are expected to be sold, consumed or converted to cash within the current fiscal year through the normal course of business.

Current liabilities are those liabilities or debts that are due or are expected to be settled within the current fiscal year through the normal course of business.

Importance of working capital:

Working capital is an essential used by financial institutions, suppliers, and investors to judge the efficiency of a company.

It is a representation of how the company manages its daily operations which includes revenue collection, inventory management, payment to creditors, etc.

A company is considered healthy and liquid when the current assets are sufficient to pay off the current debt. Managing your working capital is crucial for getting better deals with your suppliers or banks for loans.

Accounting for working capital:

The two components of working capital i.e. current assets and current liabilities are reported on the balance sheet of the company.

Assets like accounts receivable, cash and bank, inventory, interest receivable are reported under the heading current assets in the Assets section of the balance sheet.

Short-term liabilities like accounts payable, bank overdraft, interest or dividend payable are reported under the heading current liabilities in the Equity and Liabilities section.

Working capital is also used as a financial analysis ratio. The current ratio and quick ratio is a reflection of the company’s liquidity.

A good current ratio would be between 1.5 and 2.

A good quick ratio would be greater than 1.

Calculation of working capital:

The formula to calculate working capital is:

Working capital = Current Assets – Current Liabilities

Let’s illustrate this through an example. Following is the balance sheet of Zellind limited:

Required: Calculate the working capital.

Step#1: Calculate the value of current assets.

Current assets = Cash & bank + accounts receivable + inventory

Current assets = 500 + 4500 + 3000 = $8,000

Step#2: Calculate the value of current liabilities.

Current liabilities = Bank overdraft + Accounts payable + Accruals

Current liabilities = 1600 + 2200 + 2400 = $6,200

Step#3: Apply the values to the formula of working capital.

Working capital = Current assets – Current liabilities

Working capital = $8,000 – $6,200 = $1,800

Conclusion:

Zellind Limited has a positive working capital of $1,800 meaning that it is liquid enough to pay off its current debts.

Since Zellind Limited can pay back their creditors within a year, they can even avail cash discounts on early payments as well as get better deals with banks due to a better credit score.

The major advantage of positive working capital is it helps reduce costs and increase profits i.e. the prime objective of a profit-maximizing entity.

Working Capital and Liquidation

Introduction:

Working capital is the amount incurred after deducting current liabilities from current assets of a company, it is the capital used by businesses to cover their day to day expenses of operation.

It is a measure of a company’s liquidity position and its financial strength; working capital reflects the ability of a company to settle its short term debts which are usually for a year such as payment to the suppliers for the goods purchased on credit, bank overdrafts payments and payment of expenses accrued over the year.

Liquidation is a term used to define the winding up of the business; a procedure to shut down the business and terminate its activities by distributing all the assets of the company to the creditors who have a claim from the company, settling all the debts and removing the company’s existence.

Explanation:

Working capital is an essential element for businesses as it helps them to run their operations smoothly and efficiently.

It is one of the many financial metrics used by the investors to judge the efficiency of the company and to analyze its future profitability.

A positive working capital indicates healthy financial management of the company and it encourages creditors to offer their products and services on credit to the company because they have the confidence that they will receive their payments timely.

However a negative working capital in the balance sheet of the company is detrimental to the company’s opportunity to receive loans, it levies an unfavourable impression on the stakeholders and depicts financial difficulties.

For calculation of the working capital company’s currents assets are compared with its current liabilities.

Current assets include assets which can be liquidated, turned in cash within a year such as trade receivables, bank and inventories whereas current liabilities are the debts to be paid within a year.

Working Capital = Current Assets – Current Liabilities

Example:

Company ABC

Extract from the Balance Sheet

Current Assets                                                               Amount($) Current LiabilitiesAmount($)
Inventories160,000Trade Payables200,000
Trade Receivables220,000Accrued Expenses150,000
Short term investments140,000Current portion of long term debt35,000
Bank110,000Tax payable180,000
Cash50,000    
Total680,000Total565,000

With the information mentioned above the working capital of Company ABC is:

$680,000 – $565,000 = $115,000

Company ABC has a positive working capital which normally specifies that it will immediately pay off its debts and will also be able to expand its activities and invest in profitable ventures.

However, a negative working capital often leads to the insolvency of the business which means that the business is no longer able to pay its obligation when they become due.

The business can then convert its negative working capital into positive by raising long term loans in the form of bonds or debentures or through raising shares.

However in the event of not being able to raise funds to meet the short term debts the business may be forced into liquidation which means the closing of the entity and going bankrupt.

A liquidator is appointed to dissolve the company’s operations and to convert all the assets into cash by selling them so that the claims of the stakeholders can be discharged according to their priority; the topmost claim is of the creditors who have collateral security attached to their loans such as a mortgage or a pledge.

The next to receive their claims are the unsecured creditors such as debenture holders, bondholders, suppliers or employees.

And finally, if there are any remaining assets these are given to the shareholders, in this case, preferred stockholders are given priority over the ordinary stockholders.

What is the Concept of Working Capital?

Working capital is the amount of capital revolving, circulating in the short term to facilitate the daily operations of the business. It is considered the backbone of every business as it plays a very important role in the growth of the business.

That’s why financial managers give the utmost importance to working capital management for a healthy financial position of the firm.

You can say that working capital means, the company’s investment in raw material, finished goods, cash, and receivables.

For example, for any manufacturing concern, availability of raw material is important for continuous and non-stop production, a certain amount of finished goods in the warehouse are also important for a company to continue its sales without affecting by fluctuations in the production rate, likewise, the company also needs to invest in credit sales for achieving continuous sales along with cash in hand and bank balance to meet the daily cash demand.

There are two concepts of working capital.

  • Gross Working Capital:
  • Net Working Capital

Gross Working Capital

The gross working capital is the amount of a company’s total investment in current assets. Or you can say that the total amount of short-term capital needed to run the business operations is called gross working capital.

For example, the total amount of raw material, finished goods, receivables, and cash. The gross working capital has some limitations like it did not show the real position of the business.

Because if a company borrows some loans or advances, it will definitely affect the value of current assets as the bank balance will increase which will affect the working capital in a positive way but ignores the other side of the balance sheet which shows a rise in the amount of liability.  

This concept is useful to an extent to calculate the gross amount needed to invest in current assets to run the business smoothly.

This concept is usually supported by new businesses that own the business idea but have less investment and have to borrow money from banks and other financial institutions to meet their requirement of working capital. 

Net Working Capital: 

Networking capital is the positive or negative balance of the company’s current assets over current liabilities.

In simple words, you can say that networking capital is calculating by currents assets minus current liabilities.

Current assets include inventory, cash, and cash equivalents and account receivables while current liabilities include accounts payable, outstanding expenses, or short-term borrowings.

The formula for net working capital can be defined as 

Net Working Capital = Current Assets – Current Liabilities 

Networking capital may be positive or negative depends on the values present in the current section of the balance sheet.

The result will be positive if the company has invested more in current assets supported by less current liabilities. And the results will be negative if the amount of current liabilities exceeds the value of current assets.

The negative working capital shows that the company business is at high risk as the business has more debt as compared to its own capital. But according to modern theories, negative working capital is not always a bad thing.

Because there are many situations where businessmen may have a good business plan but due to a shortage of funds, he may borrow a relatively high amount from banks and other financial institutions.

Hence in this, the networking capital will be negative but you may not consider this as a case of financial management failure. Because the owner uses borrowing as a tool to start and grow their business.

And with the passage of time and hard work, if the business plan executes well, the working capital position will start moving from negative to positive.

What is Working Capital in Financial Management?

Financial management is an important activity with a vital role in organizing, planning, controlling, and monitoring of business resources.

It helps organizations to use their financial resources in a more efficient way to achieve their goals and objectives.

The branch of financial management which deals with the efficient management of current assets and current liabilities to ensure availability of financial assets for running of the company’s operations.

Working capital management deals with the availability of liquid assets especially cash to accommodate day to day operations of the business.  

Concepts in Working Capital

There are mainly two concepts used for working capital 

  • Gross Working Capital
  • Net Working Capital

Under the gross working capital, the total value of current assets is called gross working capital.

And the management of only current assets is referred to as gross working capital management. Following are the main components of assets comes under gross working capital 

Net working capital management 

Networking capital management is the net of the company’s current assets and current liabilities. It can be expressed in a simple mathematical formula.

Net Working Capital Management = Current Assets – Current Liabilities

In the networking capital management approach, companies try to manage their assets sides as well as the liabilities side.

The formula either gives you positive value or negative working capital, depending on the total value of current assets against the total value of current liabilities. 

Following are the main components to manage under the net working capital management approach.

  • Account Receivable
  • Inventory
  • Cash & Cash Equivalents
  • Accounts Payable

Objectives of Working Capital Management:

Working capital management has a number of objectives, but some of its primary objectives are as follows

 Continues operations

One of the primary and most important objectives of working capital is to facilitate and smoothen business operations. It means, to avoid any kind of problems which may arise due to the shortage of any current asset, 

for example, purchasing of raw material, payment to workers, and payment to fulfill tax liability. This part is mainly concern with the availability of cash and cash equivalents. 

Keep Working Capital Under Control:

Working capital is an important part of the company’s paid-up capital and if it goes out of control then there is a high risk of insolvency of business, or the company may sell out some of their long-term assets to fulfill the requirements of working capital.

Because it becomes very difficult for entities to operate with a shortage of working capital. So, for achieving a smooth operating cycle, it is important to keep the working capital requirement on the lowest side.

This objective can be achieved by managing the receivables turnover period and extend the payable period by dealing with creditors of the company along with effective inventory management. 

Lowest Rate of Interest:

The current portion of interest payable is count under the head of current liabilities, so it should be managed properly to achieve a high level of profits.

If a business wants to take a loan from any bank or financial institution, it should be well negotiated and try to win the loan on a minimal interest rate.

Benefits of Working Capital Management

If the working capital is managed in a well and professional way, there are a lot of benefits which can be achieved by entities. And if the management fails to manage working capital in a proper way then it will cost the business.

Following is the list of benefits of working capital management 

  • High profits than normal 
  • Increase the credit rating for the business
  • A high amount of liquid assets  
  • Stable business condition 
  • Continues production 
  • Gives Competitive advantage in the market.

How to Calculate Working Capital?

The formula used to calculate working capital of any business is

Current Assets – Current Liabilities = Working capital

If we further explain the formula, we will find that working capital is the value remaining after deducting of all short-term liabilities from the liquid assets of the company.

This is an important tool used to evaluate the ability of a business to pay off its current liabilities. This tool is also used by management for financial analysis, financial modeling and managing cash flows of the business.

The working capital formula focuses on the ability of the company to pay back its debt which will be due in the next 12 months, that’s why the company’s creditors and vendors always adjust their business with the company on the basis of these calculations.

Impact of Positive or Negative Working Capital

If the value generated from the formula is positive, it means that there is a sufficient amount of liquid assets available with the company to meet its current liabilities while in case of negative results, it shows that the company may not be able to meet its liabilities due in next 12 months.

This situation will force the company to use its long-term assets or get some extra loan from outside to meet its currents liabilities which is always a bad Indicator for any business.

Important Components of the Formula

The working capital formula is the comparison of the balance sheet current portion i.e. current assets and current liabilities. In most cases, current assets include cash, account receivable, inventory, and short-term investment of the company.

While the current liabilities typically include all short-term trade payables, accrued expenses, short term advances received, and any short-term debt.

Example:

The balance sheet of Blue-end Company is as follows

Assets Liabilities and Equity
Current assets: Current liabilities:
Cash and cash equivalents $ 2,000 short term debt $ 1,200
Accounts Receivables $ 2,500 Accounts Payables $ 3,000
Inventories $ 3,500 Accrued Liabilities $ 2,000
Total Current assets $ 8,000 Total current liabilities $ 6,200
Non-current assets: long term liabilities:
Property, Plant and equipment $ 12,000 long term debt $ 5,000  
Investments $ 1,500 Equity:  
other non-current assets $ 500 Preferred Stock $ 2,000
Total Non-current assets $ 14,000 Common stock $ 7000
Total Assets $ 22,000 Retained earnings $ 1,800
    Total Equity $10,800
    Total Liabilities and Equity $ 22,000  
       

Required:

Calculate working Capital

Solution:

Function for Working capital = Current Assets – Current Liabilities

Current Assets=Cash & Cash Equivalents + Account Receivable + Inventories

Current Assets = $2,000+$2,500+$3,500 = $8,000

Current Liabilities = Short Term Debt + Account Payable + Accrued Liabilities

Current Liabilities= $1,200+$3,000+$2,000= $6,200

Put the values in the formula

Working Capital= $8,000 – $6,200   = $1,800

Explanation:

After all the calculation we find that the value of Blue-end current assets is more than their current liabilities which results in positive working capital.

Now we can analyze that there are sufficient funds available with the company to pay their current liabilities.

In other words, we can conclude that Blue-end have a sufficient amount of liquid assets which can be used to grow the business without affecting the current liquidity position of the company.

How company can improve their working capital in positive direction?

Companies can improve their liquidity position in 3 different ways. Like, management can analyze company’s account receivables and make strategies to shorten the period of recovery time of their account receivables, in the second way company may adopt some strategies to keep the inventory position on a very suitable level on the basis of company needs and supply of material, while another way could be that the company may deal with creditors of the company to extend their credit period for a bit longer than the normal period.

These strategies will increase the availability of hard cash in the business which will positively affect the net working capital of the company.

Key Components of Working Capital

The difference between a company’s current assets and current liabilities is called working capital. You can say that the working capital is the number of liquid assets which are using by the company to conduct their business.

Working capital should be efficiently used in order to achieve long term growth and profitability.

It is one of the major tool for management and creditors to evaluate the current position of the business.

Management uses working capital analysis to assess liquid assets in a more meaningful way i.e. the proper management of cash flows and inventories while the vendors and creditors are using working capital calculations to access the company’s ability to pay their debt in time or not.

Formula for Working Capital

The formula for working capital is

Working capital = Current Assets – Current Liabilities

So, if you want to calculate the working capital for your business, first you have to understand all the components involved in calculation of working capital.

Components of Working Capital:

Current Assets:

Current assets are the one side of working capital formula. They can be defined as, type of assets which are easily convertible to cash in less than one year are called current assets.

Current assets  are mainly utilized to meet the requirements of daily operations of the business.

Working capital management is mainly controlled by managing current assets of the business.

Current assets are composed of cash and bank balances, trade receivables, short term advances, prepaid expenses, inventory and short-term investments.  Let us understand some of components in the below section

Cash and Cash Equivalents

You will see the term cash under the current assets in the balance sheet. This is the most liquid of funds and very essential for every business to maintain the smooth operations of their business.

Sufficient amount of cash should be present with the company to fill any unexpected gaps in the production and sales cycle.

Account Receivables:

The account receivable is the amount of money receivable from clients arises due to credit sales by the company in the normal course of business. You will find account receivables on the company’s balance sheet under the current assets.

The important point is that they are classified as assets but in real, they are not available for usage until realized in more liquid form.

This is an important component of working capital management and should be efficiently manage to improves the financial health of the company’s operations.

Inventory:

Stock / Inventory are the goods, which purchased by company with a view to resell in the market and earn profits. The turnover of inventory determines how the successful the business is.

Accounts Payable:

Accounts payable are the obligation upon company to pay off its debt due from its creditors, and suppliers.

Accounts payable comes under the head of current liabilities and one of the major components of working capital management. Accounts payable can be managing through negotiations with creditors to extend the payment period.

Like the management of account receivable and inventory, accounts payable management is also a key component in managing working capital.

If the company fails to get a longer period for its short-term debts while its own collection period is slightly longer as compared, then there is a chance that the shortage of cash may arise. Which may lead to financial crises.

So companies should have managed their accounts payable in a way that average days of payable outstanding should be less than the average collection period of the company. So that company will continue its operations without any problem.